More than two years after the appellate briefing was completed, the Sixth Circuit has finally issued its decision in Quality Stores. (See our previous coverage here.) The court ruled that severance payments paid to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes. In so holding, the Sixth Circuit expressly declined to follow the Federal Circuit’s contrary decision in CSX Corp. v. United States, 518 F.3d 1328 (2008).

The court agreed with the taxpayer’s argument that the severance payments are not literally “wages” under the Code. Although Code section 3402(o) provides that “supplemental unemployment compensation benefits” (which the court found to include these severance payments) should be “treated . . . as wages” for income tax withholding purposes, there is no analogous directive for FICA. At the same time, relying on Rowan Cos. v. UnitedStates, 452 U.S. 247 (1981),the court ruled that the definition of “wages” is the same for income tax withholding and FICA purposes. (As discussed in prior posts, the government argues that intervening legislation has made Rowan no longer good law for that proposition.) Therefore, the court concluded, the Code does not make the severance tax payments subject to FICA taxation.

The government is likely to seek further review in this case. Given the clear circuit conflict, and the importance to the case of the continuing vitality of the Supreme Court’s decision in Rowan, this issue is certainly a candidate for Supreme Court review down the road.

A petition for rehearing is due on October 22. A petition for certiorari is currently due on December 6. That date would be pushed off if the government seeks rehearing.

The Second Circuit today affirmed the Tax Court’s decision in Union Carbide denying the research and experimentation credit for the costs of certain supplies used in production process experiments that sought to improve a process that was already in use for producing products. The court concluded that the credit is available only for the costs of supplies that would not have been incurred but for the experiment; hence, it disallowed the credit claim for the costs of other supplies that concededly were necessary for the experiment because they are otherwise necessary for the production process, but would have been incurred anyway if production had proceeded without the experimental process.

As discussed in our prior post, the taxpayer’s argument rested primarily on the plain meaning of the statute, which states that the credit is available for the cost of supplies “used in the conduct of qualified research.” 26 U.S.C. § 41(b)(2)(A)(ii). The Second Circuit held that this language is not sufficiently clear to carry the day without further inquiry. First, the court rejected the general proposition that dictionary definitions are dispositive. Second, the court stated that the taxpayer’s analysis improperly focused on the single word “used,” when it should have looked to the meaning of the more ambiguous complete phrase “used in the conduct of qualified research.”

The court then stated that it agreed with the Tax Court that the taxpayer was seeking a credit for “indirect research costs,” which are excluded from qualified research expenses under Treas. Reg. § 1.41-2(b)(2). The court did not find the regulation itself conclusive, recognizing that the regulation did not clearly explain “how one distinguishes between direct and indirect research expenses.” But the court found that this clarity was supplied by the government’s brief, stating that, on the authority of Auer v. Robbins, 519 U.S. 452, 461-62 (1997), courts “ordinarily give deference to an agency’s interpretation of its own ambiguous regulations, even if that interpretation appears in a legal brief.” (We note that Justice Scalia, the author of Auer, recently remarked that this approach is problematic because it encourages agencies to issue vague regulations and then obtain deference to their own interpretations of those regulations without subjecting the interpretations to notice-and-comment review. No other Justice, however, joined Justice Scalia’s statement that he would be open to reconsidering Auer. SeeTalk America, Inc. v. Michigan Bell Tel. Co., 131 S. Ct. 2254, 2266 (2011) (Scalia, J., concurring)) The Second Circuit in this respect is taking a step beyond Auer, where the agency’s interpretation was found in an amicus brief filed by a non-party rather than by a party trying to defend a particular result that is in its pecuniary interest.

The Second Circuit added that deference to this interpretation was appropriate because, based on a House Report, the court perceived the purpose of the credit to be “to provide a credit for the cost that a taxpayer incurs in conducting qualified research that he would not otherwise incur.” According to the court, “[a]ffording a credit for the costs of supplies that the taxpayer would have incurred regardless of any qualified research it was conducting simply creates an unintended windfall.” Judge Pooler did not embrace this part of the opinion, writing separately to note her “view that Congress may well have intended to give a tax credit for those supplies which would have been purchased absent any qualified research.” Because Congress had not expressed that intent clearly enough “so as to preclude either the Commissioner’s regulations or his interpretations,” however, she joined the majority in affirming the Tax Court.

The Union Carbide decision is a blow to manufacturers hoping for a broader reading of the R&E credit. The extent of its impact remains to be seen. R&E credit cases are fact-intensive, and the facts of this case were relatively unsympathetic to the taxpayer in that it sought a credit for costs that unquestionably would have been incurred anyway – even without the experiment – and that produced a product that was sold. Other cases involving less established processes could yield different results. And, as noted in Judge Pooler’s concurring opinion, Congress has the last word on this topic if it determines that the Second Circuit’s approach does not create a sufficient incentive for research and experimentation.

As previously reported here a few weeks ago, PPL filed a petition for certiorari asking the Supreme Court to review the Third Circuit’s decision denying a foreign tax credit for U.K. Windfall Tax payments. Given that the Fifth Circuit had decided the same issue in the opposite way in the Entergy case, there was a significant possibility that the government would not oppose certiorari, but instead would urge the Court to resolve the circuit conflict.

The government has now decided that its interests in resolving the conflict and potentially securing a reversal in Entergy outweigh its interest in preserving its victory in PPL, and accordingly it has filed an “acquiescence” in PPL urging the Court to hear the case. In that brief, the Solicitor General makes his case for why he believes PPL was correctly decided and also for why the issue is sufficiently important to justify Supreme Court review.

On the first point, the government’s brief rejects the characterization of the U.K. Windfall Tax as an “excess profits” tax. Instead, the government says, it is “a tax on the difference between the price at which each company was sold at flotation and the price at which it should have been sold, based on its ability to generate income.”

On the latter point, the government acknowledges both that the “specific question presented in this case is . . . unlikely to recur or to have significance for a large number of U.S. taxpayers” and that, “[b]y their nature, issues regarding the regulatory tests set forth in 26 C.F.R. 1.901-2(b) will necessarily arise in cases involving specific foreign tax laws that are unlikely to affect a large number of Americans.” But the government concludes that, “[n]evertheless, this Court’s guidance on the correct analytical approach for evaluating foreign taxes under Section 901 and the Treasury regulation may have significant administrative importance beyond the specific foreign tax law at issue here” and that the interest in uniform enforcement of the tax laws further justifies Supreme Court review.

Concurrent with its filing in PPL, the government filed a “protective” petition for certiorari in Entergy. In accordance with the Solicitor General’s common practice in situations where two different cases present the same issue, that document does not ask the Court to take immediate action. Instead, it asks the Court to hold the petition and to dispose of it as appropriate in light of the final disposition of the PPL case. The Court is likely to follow that advice, which means that if the PPL petition is denied, or if the decision is overturned, the Court will just deny the Entergy petition. If the PPL decision is affirmed, the Court would then grant the Entergy petition, vacate the Fifth Circuit’s decision, and remand the case for reconsideration in light of the Court’s intervening decision in PPL.

But that is getting ahead of things. First, the Court must decide whether to hear the issue at all. It has no obligation to do so, even though both parties recommend certiorari. Presumably, the Justices have not been dreaming about the opportunity to wade through the foreign tax credit regulations, and their inherent interest (or lack thereof) in the subject matter could tip the balance if they believe the question of importance of Supreme Court review is a close call.

The PPL petition is scheduled to be considered at the Court’s October 5 conference. An announcement of whether certiorari will be granted will most likely issue either on that date or on October 9.

About Miller & Chevalier’s Tax Appellate Blog

Miller & Chevalier was founded in 1920 as the first federal tax practice in the United States. For nearly 95 years, the firm has successfully represented the most sophisticated corporate clients in all facets of federal income taxation. Miller & Chevalier’s Tax department serves clients headquartered throughout the U.S. and around the world and, over the past several years, has represented approximately 30 percent of the Fortune 100 and more than 20 percent of the Global 100. Our clients come to us to solve the thorniest of tax issues, and we have litigated many of the most significant tax cases on record.

The Tax Appellate Blog is intended to be a resource for information on important tax cases under consideration in the appellate courts. It will feature insightful commentary on the issues and provide a dedicated site for following the progress of these cases.

Authors

Steve Dixon is a Member in the Tax Department at Miller & Chevalier. He specializes in controversy and litigation, representing taxpayers in the Tax Court and Federal courts.

Laura Ferguson is a Member of the Supreme Court and Appellate Litigation Group at Miller & Chevalier and has successfully briefed and argued six cases at the U.S. Courts of Appeals in the past two years. Ms. Ferguson also has extensive experience litigating complex, high-stakes tax cases at the Tax Court and federal district courts.

Alan Horowitz is the former Tax Assistant to the Solicitor General at the Department of Justice, where he briefed and argued numerous tax cases in the Supreme Court. He is currently the head of the Supreme Court and Appellate Litigation Group at Miller & Chevalier.